What Are Debt Securities and Are They Good Investments?

How Debt Securities Work

A debt security is an investment asset that involves a debt rather than ownership in a company. A common example is when a corporation or government agency issues a bond and sells it to investors. An investor can buy this debt security and hold onto it until the bond matures or until they choose to sell it to someone else.

Debt securities come with specific terms, including the amount borrowed, the interest rate, how often interest payments are made, if (or when) the security can be renewed and the maturity date.

Debt securities are generally low risk compared with stocks, though risk levels can vary depending on the type of debt security and the issuer. For example, corporate bonds carry more risk than government bonds because the companies that issue them could default on the debt or declare bankruptcy.

Here are a few of the more common types of debt securities you can invest in:

• Bonds: These securities are issued by corporations or government agencies to raise money for specific projects or for general needs. Risk levels and interest rates vary depending on the financial soundness of the bond's issuer, with higher-risk bonds paying higher interest rates. Bonds are typically sold at face value, which is the amount the issuer is borrowing, but prices can vary based on market interest rates, with prices increasing with lower rates and vice versa. However, some are sold at a discount and mature at their face value. Maturity terms can range from one month to 30 years, at which point the original debt must be repaid.
• Preferred stock: Preferred stocks are hybrid securities that share traits with both stocks and debt. They're issued at face value and pay dividends based on that amount. Like traditional stocks, their market value can fluctuate with the company's performance. This value is generally more influenced by market interest rates, however, much like bonds.
• Commercial paper: Large corporations sometimes use commercial paper to finance short-term financial obligations. These securities typically have a maturity of 270 days or less but can go longer. They typically sell at a discount and pay interest, maturing at their face value.
• Mortgage-backed securities: These debt securities are created when a company buys mortgage loans from lenders and pools them together into packages to sell to investors as a single security. These securities are backed by the homes that secure the individual loans. They pay out in fixed, periodic amounts based on a predetermined interest rate.

Are Debt Securities a Good Investment?

It's always a good idea to diversify your portfolio across different asset classes, and debt securities can be an important part of that strategy. Here are some advantages and disadvantages to consider before investing in them.

Pros

• Lower risk than stocks: Debt securities aren't as volatile as stocks in the short term, so having them could help reduce your overall portfolio risk.
• Income payments: It's great to watch your investment portfolio grow via stock price appreciation, but some investors also like to earn some income along the way. If that's something you're interested in, debt securities can be a great way to do it. What's more, the income payments are generally fixed, which gives you more predictability.
• Good for capital preservation: If you're planning to retire in a handful of years, you may not want to risk keeping the majority of your portfolio wrapped up in high-risk investments. While you should consult a financial advisor about the proper ratio, adding more debt securities as you near retirement can better ensure that you retain the wealth you've accumulated.

Cons

• Lower returns than stocks: Lower risk generally means lower returns, and debt securities are no exception. While they're great for risk mitigation, focusing too heavily on debt securities can be a detriment to your long-term investment strategy.
• They're not entirely without risk: Treasury securities are generally considered to be risk-free because they're backed by the federal government, and municipal bonds issued by local governments tend to be low-risk as well. But some corporate bonds can carry the risk of default or bankruptcy. Also, remember that as interest rates increase, debt security prices typically go down, which is something you'll want to keep in mind if you don't plan to hold onto it until it matures. Finally, some debt security issuers can buy back their debt early if interest rates drop and issue new ones with lower interest rates.
• Less liquidity: Individual debt securities are generally more difficult to buy and sell than stocks. They also require large investments. For example, a corporation may issue bonds with a $1,000 face value, but you'll have a hard time finding a company that will sell you just one. As a result, it's typically best for most investors to invest in debt securities via mutual funds and exchange-traded funds.

Where to Buy Debt Securities

You can purchase debt securities directly from the issuer, but that can be difficult depending on the type of security you're interested in buying. For example, commercial paper may require large investments ($100,000 or more) that many investors can't afford.

For government debt securities, you can buy directly from the government or through a broker or dealer.

For most people, though, your best bet is to go through a brokerage account. This is not only simpler, but it also provides more options for diversification. In particular, buying debt securities through mutual funds and exchange-traded funds can allow you to achieve your goal without a huge cash requirement. These funds may also buy a diverse range of debt securities, so the risks associated with individual bonds are less pronounced.

Consult With a Financial Advisor About Your Investment Strategy

If you're thinking about investing in debt securities, it might be worth consulting with a financial planner to get an idea of how they fit in your portfolio. An advisor can provide you with objective advice that's personalized to your needs and goals and even help you manage your investments for a fee.

If you'd rather not engage an advisor, consider sticking to mutual funds and exchange-traded funds to keep things simple and diversified.

When making any major investment decisions, make sure your financial obligations are covered, your emergency fund is flush and your retirement plans are on track. Experian can help you monitor your credit, which is an important part of your financial health.